Featured Article

Convenience Comes at a Cost

dondawson
Don Dawson
Instructor

Many Futures traders often face that decision of just how bad they want to get in or out of a market position. Sometimes they realize that the market did not trade at their price targets and the price appears to be leaving without them. Other times a market might be making an adverse move against them and they want to place a very quick G.M.O. (Get Me Out) order. During these times of such urgency, a trader rarely thinks of the cost to use such an immediate type of order execution. These urgent types of orders are called market orders.

Many traders prefer to use either a stop or limit order to enter or exit the market. Using these orders allows the trader to specify their price and place the order in the market and wait for price to come to them. With market orders, a trader is looking to immediately enter or exit the market and is not willing or able to wait for a better price. Using a market order does not have any surcharges from your broker to increase your commissions, but they do have associated opportunity costs.

  • Limit Order – allows trader to select the price to enter or exit at and if filled, guarantees the trader that price or better. The problem is the fill is not guaranteed and the trader stands to miss the trade possibly.
  • Stop Market Order – this order can be used to enter or exit a position in the Futures markets. Once the market trades at this price, the order instantly becomes a market order. This allows the trader to be guaranteed a fill, but not guaranteed a price to be filled at. At times, there may be some slippage (market does not fill order at stop market price due to liquidity issue at the time price was hit) with this type of order.
  • Market Order – involves placing an order that will be filled instantly: Buy at the market order is filled at the nearest Ask in the market/Sell at the market order is filled at the nearest Bid in the market.

Table 1 shows that the bid price is lower than the ask price.

1350.75 < Ask Price
Bid Price > 1350.50
Table 1

As we study Table 1, we can see that the ask price has a limit order to sell at 1350.75 and the bid price has a price to buy at 1350.50, also known as the bid-ask spread. Since both of these prices are limit orders, somebody has to surrender their desire to make a market at these prices, or another trader must step in with a market order. The reason is that the bid and ask must match up to create a trade. Table 1 shows a one tick spread between the prices. No trade can be made until we have a willing buyer at the current ask price and a willing seller at the bid price. This is where the market order comes into play.

When using a market order, you are always buying one tick higher (ask) and selling one tick lower (bid) than the last price traded. These orders allow limit orders to be executed during the trading session. Without market orders, the market would just sit still because the two limits cannot trade with each other. Just look at your price ladder during the trading day and you will never see the last bid and ask at the same price; there is always a minimum of one tick difference between them.

There are many short-term traders and computer programs that trade for these small price changes and use market orders all throughout the trading session. Obviously, there are longer time frame traders who wish to enter and exit positions with these market orders, too. Imagine these market orders as a way of providing liquidity in the markets to move price in the bid-ask spread.

So, what is the cost of this convenience to enter and exit the market so easily?

We will use the ES (E-mini S&P) Futures contract as an example.

The ES has a tick value of $12.50 for each minimum price increment it makes.

Let’s say you trade the ES 5 times per day and each time you do, you place a Market Order to enter the trade. Since you are giving up one tick for the convenience of using a Market Order, you are giving up 5 extra ticks per day. That comes out to (5 Trades * $12.50 per tick = $62.50 per day). Still does not sound like much does it?

Let’s take this example a little further…

Now, we all trade more than one day a week. If we trade 5 days a week, we can figure that our costs have just gone up even more ($62.50 per day * 5 Days = $312.50 per week).

So, the week is over and we come back for the next few weeks to trade. We continue to use a Market Order to enter our trades. There are 4.33 weeks per month of trading ($312.50 per week * 4.33 weeks per month = $1,353.13 per month). Remember, this is just one more expense that you have to make up for each month you trade just to get back to breakeven.

Wow, this is getting expensive! Let’s see what our annualized cost will be using the Market Order for just your entry ($1,353.13 per month * 12 months per year = $16,237.56 per year)!

We will obviously be taking some time off during the year. So, let’s say we take 3 weeks off from trading. Our new cost each year for using a Market Order for entering a market will be (49 weeks of trading * $312.50 per week = $15,312.50 per year).

Keep in mind, this calculation is for entering the market only. What if we used a Market Order to get in “and” out of each trade? ($15,312.50 for entry & exit * 2 = $30,625.00 per year)!

Does this mean a trader should not use a market order? Absolutely not! I am merely suggesting you limit the number of times you actually use them. Some traders get in the habit of using them and never realize the cost they are incurring by doing so. This is why it is important to find your levels for entering and exiting your trades, then placing your limit or stop orders in the market. By doing this, you will not be forced or encouraged to use the market order button so many times.

“You’ve got to get up every morning with determination if you’re going to go to bed with satisfaction.” George Lorimer

Trade well my friends,

– Don Dawson

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.